Q:

Subject: Depreciation Recapture

For purposes of determining the basis of the relinquished property (single family rental dwelling) in a 1031 exchange, do we need to recapture the depreciation on the property taken on the straight line method? Please help.

A:

The depreciation you have claimed on the old property does reduce its costs basis on your books.

However, you do not have to recapture – pay tax on –  any depreciation because of the 1031 exchange if your replacement property meets or exceeds the target price and you don’t take any cash (aka boot) out from the transaction.  The basis of your old property is rolled into your new replacement property, via IRS’s Form 8824.

If you do take some cash out or acquire a property for less than the net sales price of your old one, you will have taxable gain to report, which will be the depreciation recapture because that is subject to the highest tax rate (generally 25% for IRS).

I hope this helps you understand the process a little better.  Your personal tax advisor should be able to fit this to your specific numbers.

Good luck.

Kerry Kerstetter

Q:

I have a friend that is going through a very nasty divorce in the state of Georgia.  The divorce has been made more complicated by a joint interest held in a beach house with another couple.  They are going through negotiations at this time to liquidate their interest in the beach house, but they aren’t sure how that liquidation is going to be taxed.  Husband makes 80k, wife makes 50k.  They are jointly to receive 115k (57.5k each) from the sale of their interest in the beach house.  They arrived at this figure by having the house appraised (450k) less the note still remaining on the house (200k) dividing by two since there are two couples co-owing the home and then dropping the price 10k to motivate the other couple to buy them out.  
 
I am nowhere near an accountant and don’t claim to be but have done some online research for my friend and as I understand it…..since the house was appraised with contents, that amount along with other landscaping improvements can be deducted from the amount of the capital gains.  And then if I am reading your site correctly, the remaining amount would be taxed at 15%.  Now….big question is, is the sale also included in their “income” which would put the wife in a higher tax bracket?  Or, is it simply noted somewhere else as capital gains?
 
I would appreciate any light you could shine on this question.  Thank you so much for your help!

A:

There are several issues that “your friend” needs to cover in regard to this matter when consulting with a tax pro, such as the following.

How was the beach property being used?  If it was rental property, there are issues of depreciation recapture and the possibility of using a tax deferred 1031 exchange to reinvest the proceeds into new real estate.

If it was only used personally, there won’t be any depreciation recapture and it doesn’t qualify for a 1031 exchange.

As you describe it, the husband is selling a 25% share of the property and the wife is selling a 25% share.  Using your figures, each would be reporting a sales price of  $107,500.  IRS treats the $50,000 relief of debt that each will be receiving the same as cash.

You didn’t say how much the property cost.  When calculating the gain on the sale, you need to properly determine your cost basis in what is being sold.  This would start from 25% of the original purchase price, plus any capital improvements, as well as any furnishings and appliances that were purchased and included with the property.  Depreciation that had been, or could have been, claimed reduces the basis.

The effective tax rates on the gain will be affected by their other income.  A lot of other income could very easily push part or all of the gain into the higher 15% Federal rate, and would be calculated using the worksheets on page 2 of Schedule D. 

There will also be Georgia income tax to pay.

A tax pro can give more precise advice based on your friend’s particular circumstances.

Good luck.

Kerry Kerstetter

Q:

I read with interest your answers to questions concerning 1031 exchanges, particularly converting a rental home to personal use.

I have a rental home acquired in May 2004 thru a 1031 exchange. Due to some unforeseen circumstances, I may need to move into this home and make it my personal residence as of  August  2005. My tax preparer indicates to me that if I live in it for 2 years I will be able to use the tax free exclusion due to the fact that the exchange was done before October 2004 when the 5 year rule was put in place.He indicates  that any exchanges or sales done before October 2004 are covered by the old 2 year rule.

I would appreciate your opinion on this matter.

A:

I covered this here:
http://www.taxguru.net/2004/10/selling-converted-exchange-property.html

Kerry Kerstetter

A reminder to please use the search tool at the top of this page to see if I have already discussed a topic before sending me questions.  I use it all the time myself to go back over the several years of postings.  I do not have time to repeat myself or send everyone the links to individual postings.

Q:

Subject: Please help me undertand:

 

OK – My Personal Residence is worth 2.5 Mil.

My Wife & I moved in 10 yrs. ago but it was purchased out of proceeds from a couple 1031 roll-overs started in 1985 and that original purchase was $85,000.00

I want to sell and buy a lesser personal residence priced at 2.0 Mil. Can I take the $500,000.00 and put in my pocket with no further tax consequence or do I get hammered for $ Two Million worth of profit.

Thank you,

A:

 There hasn’t been a residence replacement requirement since 1997, so what you do with the sales proceeds will have no effect on your tax bite.  You can see the current rules here.

If you sell the home as your primary residence, your gain will be approximately $2,415,000 assuming your cost basis is that $85,000 figure.  It will obviously be lowered by any capital improvements you have put into it and any selling costs.  It will be increased by depreciation while it or its predecessors were used for business or rental. 

You and your wife are eligible for $500,000 of tax free gain.  This means the remaining $1,915,000 will be taxable.  Except for the depreciation recapture portion, it will be taxed as long term capital gain. 

For that kind of money, you should be consulting with a tax pro.  There are a number of ways to reduce the tax hit, including recognizing any capital losses that you may have in your portfolio.  A more aggressive tax saving technique would be to convert the home to rental and then do a 1031 exchange with it

Good luck.

Kerry Kerstetter

 

Follow-Up Q:

Thank you for your reply, after my E to you I found another article, and with all due respect I have enclosed a link that states the opposite.

As I read it, the example is exactly my scenario.

Two thirds down the article please see “IS THE REVERSE TRUE”

It states I believe that when the property status is changed from a 1031 Income to a Personal Res. that the gain is deferred and the cost basis begins then. (We moved in 1994)

AM I WRONG??

http://www.1stgrand.com/Understanding_Capital_Gains_Tax.htm

A:

Actually, you are seriously misinterpreting the rules here.

Converting a home from rental to personal, or vice versa, is not a taxable event and thus does not change its cost basis.  It remains the same.

That section called “Is The Reverse True” really deals with the pre May 1997 rules for residence replacement and is no longer relevant. 

You really need to be working one on one with a tax pro on this.

Good luck.

Kerry Kerstetter

Q:

Subject: Converting property acquired through a 1031 exchange to primary residence

 I have a rental property that I acquired through a 1031 exchange and would eventually like to move into it and make it my primary residence.  The exchange took place in July 2004 and the home is presently rented for a year.  Is there a specific period that you have to wait before we can make the conversion?  Do you know of any IRS tax case law or hearing decisions regarding these types of conversions?

A:

 There is no statutory length of time required before converting a rental home to personal use.  Obviously, the longer, the better because real life events go a long way in proving intentions.

There is now a five year waiting period for a home acquired via a 1031 exchange to be eligible for the Section 121 tax free gain of up to $250,000 per person.

What is most important in regard to a conversion from a rental to personal use is that this not be pre-planned at the time of the 1031.  The idea of making the conversion must arise after the new property has been used for the rental or business purposes that qualify it as suitable replacement property for the previously owned property.  If IRS were to learn that your intention at the time of acquiring the new property was to live in it yourself, they have the power to nullify the 1031 exchange and force you to pay the taxes on the original sales, plus penalties and interest.

Not that people don’t plan these kinds of things out ahead of time.  The smart ones keep such plans to themselves and make sure all documents and witnesses can verify that any conversion plan arose well after taking title to the new property.  The stupid people shoot their mouths off about the plan, telling everyone of their intentions, and end up in deep doo-doo as a result. 

I hope this helps.

Kerry Kerstetter

Q:

Hello,

 I bought my property two years ago and I live there ie. it is my primary residence, however I have been renting out two rooms in the house. If I sell now that it has been two years later, do I still have to pay taxes when I sell the house? I have been claiming rental income on the house.

 Thanks,

A:

What you have is a sale of mixed-use property; part personal and part rental.

The sales price and cost basis will have to be allocated between the two types of property, generally based on what you have been showing on the depreciation schedule for the rental portion.

The gain from the primary residence portion would be eligible for the up to $250,000 of tax free profit.

The gain from the rental portion would be taxable unless you set that portion of the sale up as a 1031 exchange, under which you would have to reinvest the proceeds into new business, investment or rental property within 180 days via the services of an exchange accommodator.

You definitely need to be working with a tax pro in setting up the best strategy for you.

Good luck.

Kerry Kerstetter

Q:

Subject: 1031 Exchange Question

 Kerry

You have been recommended to me as someone who might have a definitive answer to a 1031 question.

 

Here is the situation:  In March of 2004 an LLC of which I am the single member purchased the Rivercliff Golf Course in Bull Shoals for $925,000.  I am in the process of selling a piece of rental property in California for $1.4 M that is in my name as an individual.

 

Is there any way I can use the purchase of the golf course as part of a 1031 exchange involving the property in California.

 

If you think there is a way I could do this please contact me and we can make the necessary arrangements.  If you don’t think this can be done I would appreciate a short reply letting me know that.

A:

What you are proposing is not possible.  You would have to replace the California property with new property, not something that you acquired more than a year earlier.

Kerry Kerstetter

Q:

If I wanted to do a sec 1031 exchange with say 7 properties (residential rental apt
buildings), each of which are in their own S Corp, in exchange for 1 property of equal or higher value (also rental property),   how is best way to structure transaction?

If you form a Partnership of the 7 S Corps & then do the Exchange, how is ownership of replacement property handled?

Can 1 of the former S Corps own the new property, or would a new S Corp have to be formed as 100% owner?

Thank you,

A:

 Since the names on the titles of the original and replacement properties need to match, there are at least a few ways in which to accomplish this that I can readily think of.

The seven different properties can be transferred into one person or entity’s name and then they can be swapped for the new property.

The easier way, and one which I have often seen done is to have each of the seven property owners exchange their property for a certain percentage of the new property.  You would use percentages sufficient to cover the equal or higher value of their old properties to cover the exchange replacement requirement. 

Later, after the dust has settled from the acquisition, the seven different entities can possibly fine tune the ownership by contributing their portions of the new property to a new entity, if that is what you want to do.  There are also several other ways you could go, including leaving the ownership divided among the seven corps, or even merging the seven corps into one.

I hope this helps. Good luck.

Kerry Kerstetter

Follow-up Q:

Kerry:

Thanx so much for the prompt reply.    I have 2 more  questions re the 1031 exchange, if you have the time to reply, I really do appreciate it.

If you are looking for property of equal or greater value as the replacement property,
what evidential matter is sufficient for IRS to establish proper mkt value of the replacement property?    Is independent appraisal for both properties sufficient?

Finally, a real estate agent advised property owner that to affect a tax free exchange, he would only have to find replacement property equal to or more than what the profit would be on the property, had it been sold & not exchanged.  

I thought you have to find new property at least with mkt value of the old property, unless there are mortgages involved on either or both properties.   Who’s correct?

Thanx again,

A:

For the 45 day identification list, values don’t even have to be shown unless you are using the 200% Rule.  For this purpose, you can use the listing prices or your best guesstimates of their values.  IRS is mainly concerned that the property that is acquired as the replacement is on the ID list and rarely looks into the total values on that list.

For  replacement purposes, it is a commonly held misconception that you only have to reinvest equal or higher than the profit.  I am constantly asked if a person can recover their investment from the sale and roll over the profit.  The answer has always been a big NO.

The target replacement price to have a completely tax free exchange is the net sales price of the old property.  This is the gross price less the direct selling costs (commissions, escrow fees, etc.).  Unlike another commonly held misconception, it is not reduced by mortgages on the old property.

Whatever the target price is missed by is considered as boot and is taxed.  IRS does not allow people to designate the boot as recovery of cost.  It is profit.

We don’t make the rules.  We just try to help people understand them properly.  Unfortunately, in spite of  the hundreds of seminars I have presented to Realtors around the country on this very topic, there are still many who don’t properly understand the details of 1031 exchanges and pass along incorrect info that could very easily get them into serious trouble if someone were to actually act on it, such as your example.  That Realtor is just itching for a lawsuit from a client who acquires a too inexpensive replacement property and ends up with taxable profit. 
I hope this helps.

Kerry Kerstetter

Final Response:

 Kerry:

Thanx again for all your info.   I too am a CPA, for many years, with a 1 man practice here in Westchester County, NY. 

This is my first exposure to actually planning for a 1031 exchange & I knew the real estate agent was incorrect, but just needed another professional’s confirmation, which is what you gave me.

If I have any other questions, I will try to keep them to a minimum, as I know we are both going thru the crazy tax season, this being my 34th!

Regards,

 

Q:

Subject: Primary Residence Sale

Hasn’t the capital gains rule of 2 out of aggregate of 5 years rule changed in Oct 2004?  Doesn’t the IRS code now require you to OWN the residence at least 5 years and live in it as principal residence at least 24 of the 60 months before sale?  Or is that just for investment acquisition?  I am darn confused here.

Thanks,

A:

The only change was for residences that were acquired as part of a 1031 exchange.  I discussed it in my blog back in October.

Kerry Kerstetter

Q:

Quick question.

Can an investment property be sold for cash and then the proceeds be used to purchase another investment property to qualify under 1031?

If the answer is yes – why would a facilitator be needed?

Or does the property actually have to be traded to defer the gain.

I am somewhat confused about the rules.

A:

Under Section 1031, you are not allowed to touch any of the proceeds from the disposal leg, even for a second.  If  you do have actual or constructive receipt of any cash, it is taxable to you, regardless of what you do with the money.

The facilitator parks the cash for you so that you won’t be considered to have had access to it.

We don’t make the rules.  Congress and IRS do that part.  We just help you understand and comply with them.

Kerry Kerstetter